Risks of Derivatives Flashcards
(41 cards)
How do exchanges minimise risk through legal obligations?
derivatives
Member firms must agree to the terms and conditions to participate in the exchanges (this can include margin requirements and setting up direct debits to cover collateral)
Who enforces the legal risk of OTC derivatives?
ISDA - International Swaps and Derivatives Association
How do the ISDA enforce legal contracts?
Create a bilateral agreement that both parties must agree to before opening a trade.
What is the ISDA’s point of contention in CDSs?
What constitutes a default event
What event lead to the scrutiny of CDS default events (credit events)
Hedge fund induced a homebuilder to miss a payment in exchange for favourable refinancing
In return the hedge fund received a CDS insurance premium and profit
In response to the CDS incident what did the ISDA institute?
Narrowly tailored credit event supplement - it sought to better define what a default event was
What did the failure to pay supplement do?
If a failure to pay does not result in the deterioration in the creditworthiness of a firm, it is not a default event.
e.g. the hedge fund default would not of counted
What did the outstanding principal balance supplement do?
If an asset was issued at a discount, the value of the CDS payment will be benchmarked against the discounted value.
What 5 things can constitute a credit event?
1) Default
2) Bankruptcy
3) Fall in asset value / price
4) Merger / Demerger
5) Debt restructuring
What constitutes a debt restructuring credit event?
If the priority or status of an asset is changed (asset covered under CDS) then a payment is due.
Once a CDS payout is made, what happens to the swap?
It is closed
What two ways can a contract be settled?
Cash
Physical
Why are CDSs bespoke and what can be tailored?
They trade OTC
What the trigger points are
Relevant to the characteristic of the underlying
What is a contango?
When the cash price of an asset is less than the forward price
Also known as a premium
What assets are normally in contango?
Why?
Physical commodities
Futures prices reflect the cost of carry making them greater than the spot price.
Why can assets normally in contango fall into backwardation?
Supply disruptions
Seasonality
Also known as a discount
What is backwardation?
When the cash price of an asset is greater than the forward price
What assets are usually in backwardation and when?
Bonds and STIRs
When long term interest rates are greater than short term interest rates
What happens to contango and backwardation as time to expiry convirges on 0
They narrow until reaching 0 at maturity
What is basis risk?
Basis risk in commodities and futures refers to the risk that the difference between the spot price of the commodity and the futures price (the basis) will change unfavorably.
When are clearing houses at most risk
When a liability is uncertain, e.g. an option
What 4 ways do clearing houses protect against risk?
1) Only deal with member firms
2) Require Margin
3) Use their own financial resources (e.g. credit line with a consortium of banks or have a default account
4) Insurance policies
What is initial margin?
The margin required to be posted at the outset of a trade.
What can be placed as initial margin
Cash or collateral (an asset with value)
